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No One Knows How Monetary Policy Works, Even in Era of Cheap Money

No One Knows How Monetary Policy Works, Even in Era of Cheap Money

Generally when you cut interest rates, it encourages businesses and households to borrow, invest and spend money. That’s generally how monetary policy works — except that’s not how it’s playing out right now.

But in the era of cheap money, which began amidst the 2008 financial crisis, it has been governments that have been doing most of the borrowing.

Per Bloomberg:

monetary policy

The numbers help explain a growing sense that central banks, which took emergency action to pull economies out of the 2008 slump, may not be able to repeat the trick in another downturn.

They’re even facing broader questions about their independence from politics, a cornerstone of economic management in rich countries. In the past decade, still-indebted private actors were mostly unwilling to dive back into the red, even at ultra-low rates engineered by the central banks — while governments could and did. The dividing line is starting to look fuzzy.

‘Fat Tail’

Some analysts say it’s time to redraw it.

The arms-length relationship between politicians and central bankers “was built when the fat tail was excessively high inflation,” said Paul McCulley, the former Pimco chief economist. “Now the fat tail is excessively low inflation, call it deflation. We need to update our thinking on a more cooperative stance between the fiscal and monetary authorities.”

Most economists see that as a slippery slope that could lead to prices spiraling out of control. That’s one reason they’re dismissive of Modern Monetary Theory, a school of thought which supports bigger deficits, and is relaxed about central banks financing them. MMT economists say public debt is generally safer than the private kind, which snowballed in the age of monetary policy dominance before disaster struck.

Debt Hangover

Private borrowers cut back after crisis — but still owe more than they used to.

debt monetary policy
The question is a live one, and not just in academia. It gets bumped up the agenda every time President Donald Trump snipes at the Federal Reserve. There are similar political pressures in other countries.